Saint Louis University – Madrid Campus
Despite central bank efforts of the past six years, there seems to be little need for money (narrowly defined) in the financial system. Mutual funds currently hold about 5 percent of their assets in cash. The size of the market for money market mutual funds, a close money substitute commonly held in investment portfolios, is at an all time low at less than 3percent of total stock market capitalization (down from over 12 percent just five short years ago). Businesses are increasingly reliant on non-bank funding, with the size of the global shadow bank industry conservatively estimated to be $75 tr. as of 2013, with $25 tr. in the United States alone (Financial Stability Board 2014). Reliance on credit amongst households, businesses and governments are at or near record highs. The banking system, the traditional originator of demand deposits (perfect money substitutes) doesn’t seem to have much of an appetite for issuing new money either. The total deposit base of $12 tr. would, if fully lent out at the applicable reserve ratio, balloon to $215 tr.
All of these examples demonstrate a clear decline in the role money serves in the modern financial economy. They also point to the importance of imperfect money substitutes in performing roles typically assigned to money. In this paper I will look at where and what function money serves in the world of finance. I will then turn to the reasons why the demand for money has declined and the demand for its substitutes has increased. I conclude with a brief look at specific reasons why the money is currently held in such low regard relative to alternative financial assets.
Money as a Financial Asset
“What you get and when you get it” are the two attributes that all financial assets can be assessed by. “What you get” refers to the type of value provided by the asset, whether market value (determined as per specific supply-demand conditions) or par value (where the payout is predefined). “When you get it” refers to the time period under which the holder can lay claim to the value contained in his financial asset. Value is unleashed either on demand or in the future, after some requisite waiting period. Creating a categorization according to the four values these two attributes can have gives rise to four different types of financial asset, as per table 1.
Table 1: Categorization of Financial Assets
Source: Howden (2015: 46)
Money is a unique financial asset in the sense that it is the only one capable of offering the holder present, or on demand, availability while at the same time trading at par value. This distinctive combination stems from the two roles that money serves in the economy. On the one hand, money functions as an exchange medium to settle pecuniary obligations. On the other hand, it is also the unit that defines prices for all other goods. When the same good functions as both the exchange medium and pricing unit, the result is a financial asset that trades at par value, on demand: money (Howden 2015).
The par value nature of money stems directly from it exchanging in terms of itself. The on-demand nature is a result of money taking on a role as the generally accepted medium of exchange. Note that the generally accepted medium of exchange is not, under this chain of reasoning, what defines money (as is commonly the case in discussions concerning the origin, role and quantity of money). It is rather a function that arises due to the widespread demand for an asset that eliminates risk and uncertainty in the payments system.
Mises (1949: 244-51) creates an equilibrium construct to show the conditions under which money is demanded by first illustrating those were it will not be. In his “evenly rotating economy”, Mises demonstrates that only under conditions of full certainty regarding the timing and magnitude of future expenditures would an individual’s demand for money fall to zero. This outcome arises as if one knew both of these criteria he could either invest his funds for the relevant time period and have the investment mature when the expenditure comes due, or settle it now on the futures market at a discount. Thus, any demand for money must stem from a demand for certainty.
Since the two relevant criteria determining the individual’s demand for money can be traced back to an uncertainty concerning the timing and magnitude of his future expenditures, it is instructive to assess those cases where only one of the criteria is unknown. In general, uncertainty can exist regarding when a future expenditure will occur, or the magnitude of the expenditure, or both simultaneously, as outlined in table 2.
Table 2: Uncertainty Types
Structural uncertainties arise when one lacks knowledge of the states of the world. Something may occur in the future, or not, but what exactly may or may not occur is not known in advance. In contrast, systemic uncertainties are those where a future state of the world is known, but whether this state will occur is unknowable. Examples of the former type typically centre on fundamentally new paradigms that seemingly come from nowhere. The Smartphone revolution, for example, or the Haitian earthquake of 2010, the Japanese tsunami of 2011, or any other such similar “out of the blue” occurrence. Systemic uncertainties occur, in some sense, much more frequently (or at least they appear that way since the outcome is known in advance), e.g., the current economic sanctions against Russia – will they continue through to the end of the year, or will they end soon? The answer to this query could just as easily be answered either way, and there is no way that the answerer could know in advance. To choose a more mundane example, the gambler knows that a die will give a number one through six 1/6 of the time, but on any such roll he is completely (systemically) uncertain – he has no idea when a certain outcome will obtain. (Over a series of rolls he could hedge his bets, but for any one roll the outcome is a complete crapshoot.)
These two specific uncertainties are important in the sense that the individual can protect himself, or hedge, against them through various financial means. To say that one is structurally uncertain about the future is to admit that the future is unknowable. This statement does not imply that the timing of the unknown future is unknown. Over the course of the individual’s life many novel events will occur that he could not have foreseen, yet all of these events will have to occur over his life. As such, he is uncertain only about the future outcomes but from the way he has bounded the question, the individual has complete certainty as to the timing of such outcomes. Something could happen to you in the future, though you have no idea what. However, you do know (at least tacitly or approximately) when this will occur. One can easily hedge for such an outcome by holding savings in the form of a bond whose maturity is within the expected range of the outcomes occurrence. Since you have no idea what the outcome will be, one can at least buy “insurance” against this outcome by having a known sum of money available to them. Since a bond pays out a fixed sum after a predefined period, it allows the individual to hedge structural uncertainties.
As a concrete example, within the next 15 years I will have young children who may or may not get sick (or have some other chance event affect them). Approximately 40 years from now I will myself be an elderly man, who may be faced with the same unknown future events. I do have a feeling for what these events will cost me (or, I can choose to “insure” myself for these events up to a specific amount), and I known when they will occur. My insurance policy for these systemic uncertainties can be bought in the form of a 15-year and a 40-year bond, both of which will make the requisite amount of money available to me at the expected moment.
Systemic uncertainties arise when one knows the outcomes but not their timing. The economic sanctions against Russian will end at some point but I have no idea when. When they do end I would like to invest in Russia to take advantage of its economic recovery (and expected appreciation of the ruble as exports resume). Since I do not know the timing of this outcome I can only prepare for it by holding a financial asset whose value is accessible at a moment’s notice, or on demand. Equities allow the holder to gain instant access to the market value of the shares. As such, holding equities will allow the individual to purchase a product allowing him to invest in Russia at that uncertain future date.
These two types of uncertainties – systemic and structural – could also be met by holding money. While this is one option, it comes at the cost of foregone interest or share appreciation over the holding period. However, there is one source of uncertainty that money can only serve as a hedge for. Returning to table 2, what is commonly referred to as Knightian (Knight 1921) or case probabilities (Mises 1949: 110-13), is the intersection of the two specific courses of uncertainty. In some sense of the word, this is what most people have in mind when they speak of “uncertainty” – you lack knowledge of the future states of the world, and whether they will ever exist (or if so, when).
Such a feeling of uncertainty can only be hedged against by holding one financial asset: money. The reason is that money is the only asset that is available both on demand and at a pre-defined, or par, value. Any demand for money must stem from a feeling of not just uncertainty in general, but Knightian uncertainty in particular – a complete lack of knowledge concerning what or when an event will occur.
Subjectivism and the Demand for Money
One of the central tenets of modern economics is that value is subjectively derived in the individual’s mind. An objective reality exists, e.g., there is something called a “car”, but the value imputed to that object is a teological construct. This does not imply that all economic phenomena are of a fundamentally subjective nature. Many facts are able to be objectively stated.
The category of goods in general exists in an objective way, though their value is subjectively determined by the individual. A price, in contrast, is an objective expression of these subjectively determined values. One of the primary benefits of a price is that it gives an objective basis from which to make choices based on the subjective valuations placed on various goods. (e.g., while the individual has a value scale placing various goods in a ranked order from most to least desired, it is their price that enables him to decide which of those choices to act upon.)
Financial assets, such as those in table 1, differ from goods in general as they lack use value. They are only good insofar as they are able to be exchanged for money which is then traded for a good that is directly useful to the individual. In short, financial assets only possess exchange value. Some of the factors that determine these asset’s values are objectively determinable, e.g., interest returns on similar products, maturity, etc. Other factors are subjectively determined by the individual, e.g., what is the acceptable level of risk, what time horizon is the asset expected to be held for, etc. Objective prices for financial assets exist to the extent that they are the result of the marginal buyer and seller formalizing their demands through exchange. The value placed on these assets, however, will ultimately be of a subjective nature and will determine whether the individual is a demander or supplier of the financial good in question at a given price.
Money is unique in several regards. Like other financial assets, its value is limited to the exchange value it has in procuring goods and services or settling pecuniary debt obligations. How highly valued it is in this exchange role is determined by the objective price array that exists at any given moment in time. Ceteris paribus, higher prices for goods imply a lower exchange value for any unit of money. Furthermore, while all other financial assets have a value determined by the qualities of similar assets, money faces no such competition. Its uniqueness stems from the fact that it is the only asset that redeems at both par value and on demand. A bond, in contrast, is valued according to how well it fares with respect to other bond-like products, i.e., yields on bonds of different maturities, risk factors, etc. An equity share is valued according to how liquid it is (i.e., how “on demand” it can be sold), its risk factor relative to other shares, etc. There is no other asset other than money that trades at par value and on demand. Money is also the only financial asset that has no risk in the sense that its value is always defined in terms of itself (it trades at par value) and because it does not have to be converted into money in order to be serviceable – it is the means of final settlement. (Unlike all other financial assets that must be converted into money, and face risk accordingly, before they can be useful.)
As a result, although the value of a sum of money is derived subjectively by the individual, its demand can only come from one objective characteristic – to settle pecuniary obligations. Assets that serve as perfect money substitutes to the extent that they trade at par value on demand, e.g., demand deposits, will likewise also have an objectively identifiable and unique demand. The source of this demand can furthermore only stem from one specific type of uncertainty, as outlined in table 2. As such, to speak of the demand for money amongst different margins, e.g., liquidity demands placing money along an access of other highly-liquid assets or a demand for certainty as to nominal future purchasing power, misses money’s main point.
If an individual was only concerned with his liquidity position – being able to quickly access his money at some unknown future point – he could hold his purchasing power in the form of an equity share and reap all the benefits that money would provide to this particular end and at lower cost. Alternatively, if the only factor the individual was concerned with was holding a pre-defined amount of purchasing power for the future he could satisfy this particular end by holding a par-value financial product such as a bond. It is only in that specific circumstance where an individual knows neither the magnitude nor the timing of his future expenditures – he is in a state of Knightian uncertainty – that he will demand to hold money.
I will conclude with some brief and sundry remarks about why the demand for money has decreased so much in recent years. Alternatively stated the question asks why the demand for somewhat similar assets, as described in the introduction, have increased recently.
The compositional shift from money and into debt or equity financial assets can only be explained as a response to an increase in one of two specific types of certainty. To the extent that an individual’s feeling of systemic uncertainty increases, that is to say, he feels more certain about when a future expenditure will arise but has no idea what such an expenditure may be, he will shift his financial assets into bond-type products. Bonds can be selected so as to mature at the time when the individual expects the unknown event to occur, and the magnitude of his bond purchase signals the degree which he is trying to purchase a hedge against these future events. The aging man becomes less uncertain of when some adverse event will affect his life as his years remaining dwindle. His uncertainty remains, however, as to what (if any) emergency will afflict him. As a result of this increased certainty concerning the timing of an emergency he can hold his purchasing power in a loan that matures at the necessary time.
Alternatively, to the extent that an individual’s feeling of structural uncertainty increases, that is to say, he feels less certain about when (if ever) some adverse event will arise but he feels more certain that something will occur, he will shift his financial assets into equity-type products. Equities will allow the holder on demand availability of a value that has yet to be determined. As such, the purchaser can hedge his uncertainty about the timing of his funding need by holding an asset whose value can always be released (or converted to money for final expenditure) at a moment’s notice.
The corollary to the preceding two paragraphs is that if the demand for money has decreased it is because the certainty of either the timing of future expenditures or the magnitude of future expenditures has increased. The rise of many financial innovations over the past thirty years has increased both of these certainties. As credit-based products become more prevalent for the retail consumer – such as credit cards or in-store credits – there is an increased certainty as to the timing of future expenditures as these can be undertaken and known in advance when they must be paid for. The result of this outcome is an increased demand for bonds that allow the holder a return while securing the nominal amount needed to pay off the accumulated debt at the appropriate date. Alternatively, the uncertainty regarding the magnitude of a future expenditure is affected by the expected volatility in the general rate of price inflation. To the extent that the great moderation over the past 35 years has resulted in a period of low and stable price inflation, individuals are much more certain as to the amount of purchasing power necessary to fund these future expenditures. (One could consider how similar the answers to the question of what the present value of their desired retirement fund would be if asked today versus five years ago, especially compared to the wildly divergent answers one would have received if they asked in 1978 and 1982 as a result of the relative constancy of price inflation in the former period over the latter one.)
As one final consideration, note that these demands for financial products – money, bonds and equities – are the result of expectations or feelings of uncertainty. These may turn out to be misplaced or incorrect ex post facto. It remains, however, these forecasts of uncertainty that ultimately determine the type of financial asset the individual holds his purchasing power in.
Financial Stability Board. 2014. Global Shadow Banking Monitoring Report 2014. Oct. 30. [Available] www.financialstabilityboard.org/wp-content/uploads/r_141030.pdf
Howden, David. 2009. Fama´s Efficient Market Hypothesis and Mises´s Evenly Rotating Economy: Comparative Constructs. Quarterly Journal of Austrian Economics 12(2) 3-12.
Howden, David. 2015. “Money”, in Per Bylund and David Howden (eds.) The Next Generation of Austrian Economics: Essays in Honor of Joseph T. Salerno, pp. 43-58. Auburn, AL: Ludwig von Mises Institute.
Knight, Frank. 1921. Risk, Uncertainty, and Profit. Boston, MA: Houghton Mifflin Co.
Mises, Ludwig von.  1998. Human Action: A Treatise on Economics. Auburn, AL: Ludwig von Mises Institute.
 Misunderstandings concerning the use of money in the evenly rotating economy have typically surrounded a confusion between money existing as a pricing unit versus a medium of exchange. While the certainty of the ERE specifically rules out any role of money as a medium of exchange, “money” still exists as a pricing unit (Howden 2009). It is questionable in light of discussion later in this paper whether such a good acting as money coincides with what a strict economic definition of money would entail.
 Of course, one could also have held a bond and sold it before maturity as needed. In this case the bond has ceased to be a par-value product, though, as the proceeds will be valued on the market as per prevailing interest rates and risk factors. As such the early sale of a bond converts it into an equity share (Howden 2015).
 Here I ignore commodity money as a financial asset and focus exclusively on its fiat alternative. To the extent that the commodity functioning as money has a direct use value to, it can be categorized as both a good and a financial asset. This categorization will be determined by the demands of the individual, and are outside the scope of this article. I also ignore share certificates that the individual may derive value from by hanging on his wall, or money with numismatic value. In short, I herein address only the value of financial assets qua financial assets.